Commodity Investment: Impact on Energy Derivaties

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1 Commodity Investment: Impact on Energy Derivaties The last four years have seen a dramatic growth in commodity index mutual and exchange traded funds (ETFs). According to Tim Guinness, of Guinness Asset Management, (Manager of the Investec Global Energy Fund) this expansion is due to both the sharp rise in commodity prices and relatively poor performance of equity markets in the earlier years of this decade. Setting the Scene The last four years have seen considerable growth in both assets and performance of commodity index benchmarked mutual funds and ETFs. From 23, funds in the largest five commodity mutual funds and the largest seven ETFs have grown from under $1 million (mn)to over $18 billion (bn). The background to this is the very strong rise in commodity prices since 1998 (see Chart 1) fuelled by, in particular, demand from China. Such high returns during a period when equity markets had to cope with a major correction have caused a number of investors to argue the case for treating commodities as another asset class for those who are seeking diversification, and then to make the case that commodity markets are enjoying a sectoral bull market which, while it lasts, will offer much higher returns than investment in the more conventional asset classes such as equities, bonds or property. Advocates of commodity investing argue that, historically, commodities markets have experienced long cycles lasting15 to 2 years or more-and add that we are now 8 years into a bull market phase, following the18 year bear market of Chart 1: Historical Price Movements for Front Month Futures Contacts Exchange End 1998 End 26 % Change WTI Crude Oil NYMEX Heating Oil NYMEX Copper LME Natural Gas NYMEX Silver CMX Aluminium LME Gold CMX Corn CBT Soybeans CBT

2 Negative Correlation with Equities The perceived negative correlation between equities and commodities (see Chart 2) also provides a tool to diversify portfolios and increase performance and/or reduce risk. Indeed, in their research paper Facts and Fantasies About Commodities Futures Professors G Gorton of Wharton and K G Rouwenhorst of Yale have recently shown that commodity returns are negatively correlated with equity and bond returns [1]. Benchmarks Facilitating Investment Over the years a number of indices have been established against which commodity investors can benchmark performance (see Chart 3). The Reuters-CRB index, an un-weighted spot price index, has existed since The Goldman Sachs index was established in The Rogers International Commodities Index and the Dow Jones-AIG Commodity Index were launched in 1998 and 1999, respectively. Traditionally, however, commodities have been difficult to gain exposure to for investors - futures trading, for example, demands high minimum trade sizes. The mutual funds and ETFs that have been established in the past 3-4 years have opened the doors of commodity investing to investors who previously only held more traditional asset classes. These indices represent highly liquid and diversified benchmarks for the commodity futures market. Since 2 a number of index-based mutual funds have been set up to take advantage of the commodity boom with current total invested assets of approximately $16bn. A large percentage of these c. 6% as estimated by J P Morgan in October Chart 2: Historical Prices of Reuters - CRB Commodity Index and the S&P 5 34 Reuters - CRB Index vs S&P / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / / 6 / 2 17 / 6 / / 6 / 24 15

3 25 - are held by institutional investors such as pension funds. The rate of investment into these funds has been rapid over the last three years but has slowed in 26 (see Chart 4). However, Fimat USA LLC, a securities and commodities brokerage, has predicted that commodities may attract as much as another $25bn of investment in 27, with most of that going into funds tracking indexes. Chart 3: Performance of the Four Main Commodity Indices Reuters/Jefferies - CRB (CRY) - Est pre 25 Goldman Sachs Commodity Index (GSCITR) Rogers International Commodities Index (RICIX) Dow Jones - AIG Commodity Index (DJAIG) AUG 98 DEC 98 APR 99 AUG 99 DEC 99 APR AUG DEC APR 1 AUG 1 DEC 1 APR 2 AUG 2 DEC 2 APR 3 AUG 3 DEC 3 APR 4 AUG 4 DEC 4 APR 5 AUG 5 DEC 5 APR 6 AUG 6 DEC 6 Chart 4: Index-based Mutual Fund Investment for Five Largest Funds 18, 16, 14, 12, 1, 8, PIMCO Commodity Real Return Strategy Fund (PCRIX) Credit Suisse Commodity Real Return Strategy Fund (CRSAX) - Tracks DJ-AIG Index Black Rock Real Investment Fund (MDCDX) Rydex Commodity Fund (RY MEX) Oppenheimer Commodity Strategy Total Return (QRA AX) 6, 4, 2, FEB MAY AUG NOV FEB 1 MAY 1 AUG 1 NOV 1 FEB 2 MAY 2 AUG 2 NOV 2 FEB 3 MAY 3 AUG 3 NOV 3 FEB 4 MAY 4 AUG 4 NOV 4 FEB 5 MAY 5 AUG 5 NOV 5 FEB 6 MAY 6 AUG 6 NOV 6 16

4 In addition to mutual funds, a number of ETFs have been set up to facilitate investment in commodities. European commodity ETFs account for approximately $2bn of investment (see Chart 5) and US commodity ETFs account for approximately $13bn. US investment is, however, dominated by the streettracks Gold Trust ($9bn) and the ishares Silver Trust ($1.4bn) - leaving the non-precious metal commodity ETFs at only some $1.6bn (see Chart 6). Chart 6: Largest US commodity ETFs (excluding precious metals) at 7 December 26 US ETF Macro Securities Depositor Brent Crude.8 Powershares DB Commodity.71 i-shares GSCI Commodity Indexed.13 Total 1.64 AUM ($bn) Chart 5: European commodity ETFs total assets under management 2,5 2, Total Assets ($mm) 1,5 1, 5 Lyxor ETF Commodities CRB Non-Energy (CRN) Euronext Paris (CNE) Easy ETF GSCI (GSNEEUR)Dow jones - AIG BGI Commodity Total Return Fund (BGICTRU) DEC 5 JAN 6 FEB 6 MAR 6 MAR 6 MAR 6 MAR 6 MAR 6 MAR 6 MAR 6 MAR 6 MAR 6 MAR 6 Hedge fund (as opposed to mutual fund) participation in the commodity sector is difficult to gauge, but J P Morgan recently attempted to estimate this by assuming a typical global macro fund would take a 1% position directly in commodities futures. Assuming a total of $114bn of funds under management resulted in a rough estimate of order $1bn of investment. 17

5 Growth in Energy Derivatives Turning now to energy specifically: the flows into commodity funds have obviously meant flows into energy derivatives. The energy exposure of the main indices are 44% (RICIX), 33% (DJAIGTR), 39% (CRY) and 66.7% (GSCITR) (see Chart 7). Chart 7: Breakdown of Main Commodity Indices funds. In my mind these are significant levels of investment, but it is worth noting they are nowhere near the number of $9bn that has had some airing in the press. These flows have, to an extent, been reflected in the fact that open interest Reuters/Jefferies - CRB Index (CRY) Goldman Sachs Commodity Index (GSCITR) Rogers International Commodities Index (RICIX) Dow Jones - AIG Commodity Index (DJAIG) Energy Constituents WTI Crude 23 Crude Oil 33.2 Crude Oil 21 Petroleum 2 Heating Oil 5 Brent Crude 33.2 IPE Brent 14 Natural Gas 13 Unleaded Gas 5 Unleaded Gas 12 Heating Oil 1.8 Natural Gas 6 Heating Oil 5.5 IPE Gasoil 1.2 This implies a flow of funds from commodity mutual funds and ETFs into energy markets of some $8-9bn out of the $18bn of total assets under management. On top of that we have potentially, say, $4-5bn from hedge Gasoil 4.8 RNOB Gasoil 3 Natural Gas 8.4 Natural Gas 3 Energy Total Soft Commodities Total Metals Total Chart 8: Total Open interest in NYMEX WTI Futures in the energy derivative markets has increased significantly over the last three years with, for example, the total open NYMEX crude oil futures contracts increasing from.5mn in 2 to 1.3mn today (see Chart 8). Total Open Interest (No. contracts, each worth1bris) 1,4, 1,2, 1,, 8, 6, 4, 2, DEC 95 NOV 96 NOV 97 OCT 98 OCT 99 SEPT SEPT 1 AUG 2 AUG 3 JUL 4 JUL 5 JUN 6 18

6 Getting behind these numbers is not straight forward. NYMEX itself disaggregates them into commercial and non-commercial. Commodity index-based mutual funds are not included as non-commercial interest but instead fall into the commercial category. The number of commercial long futures within the above total has increased from.3mn to.8mn contracts over this period. This increase of.5mn commercial long contracts represents an increase in underlying long oil exposure of 5mn barrels. This represents $25bn at $5/barrel and we would surmise some meaningful proportion of this reflects the $8-9bn of commodity mutual fund and ETF energy related investment flows observed above - although it will be less than the headline figure as some of the positions will be taken in other energy commodity contracts such as the London ICE energy futures market where Brent futures are principally traded (and no commitment of traders data is published). In mid January the total Brent open interest figure was about.6mn contracts. Recent Market Trends Turning to the NYMEX non-commercial futures, the net position is of greatest interest and, as shown in Chart 9, this has peaked four times in the last three years at 8, contracts net long. Again we might surmise this a value at $5/barrel of $4bn could represent hedge fund positions. Not surprisingly recent big moves in the oil and gas prices have also been preceded by changes in the non-commercial net open interest. The recent contango in the commodity markets, whereby prices close to Chart 9: Net NYMEX Non-Commercial Open Interest and Oil (WTI) Price 12, 1, 8, 6, 4, NET LONG Contracts 2, - -2, -4, -6, Oil Price (US ) -8, -1, NET SHORT 1 19

7 delivery are less than for dates further away, has been attributed to increased investor interest. Larger positions in the open interest in longer dated contracts appears to be driving this contango further into the future and is artificially influencing producers to increase stockpiling of products. The recent flows of investment into the commodity sector looks set to continue, despite recent falls of 15% over 26 for the Goldman Sachs Commodity Index and 7.4% for the Reuters/Jefferies-CRB Index (see Chart 3). The long term prospects for economic expansion in China remains strong, underpinning demand and driving commodity prices well into the future. Index-based mutual funds may suffer from increased rollover costs arising from long term contango in the commodity markets, however, and some commodity-related investment may move more towards hedge funds, who are able to profit from any downward shifts in prices. Some Conclusions Some commentators have questioned whether this financial investor-driven expansion in energy derivative markets is such a good thing. They have argued it creates unwelcome volatility. Personally, I am convinced this thinking is incorrect. More participants are likely to lead to markets being less, not more, volatile and certainly more efficient. I see no convincing evidence from history (think of 1974, 1979, 1985, 1991, 1998) that markets are any more volatile than they were. The oil price rose eight fold in the 197s from the average price of the 15 years prior to To date it has risen at its peak only some three fold from the average price of the 15 years prior to 23. Regardless of volatility, however, the great merit of markets is they act to help companies and governments allocate resources rationally and to take better decisions. If commodities are becoming scarce, for an efficient and effective supply response it is important that prices rise to encourage new investment and the development of alternative energy sources. Will the growth in energy futures and other derivatives continue? This will likely depend on how the future for energy and commodity prices unfolds. If those who believe, like me, that we are only part way through a long cyclical upturn in commodity prices are right, the growth in energy futures and other derivatives will continue for some time to come. This cycle appears to be driven by the demand growth from multiple emerging economies around the world, all of which have now entered the energy intensive stage of economic growth that seems to accompany the raising of GDP per capita from $3, per head to $1, per head. In my opinion this will not be over quickly. [1] G Gorton and K G Rouwenhorst, Facts and Fantasies About Commodity Futures, Financial Analysts Journal, 62:47, March/April 26. 2